1. Performance Ratios
Return on Equity:
(Income After Tax, Before Common Dividends and Extraordinary Items / Total Shareholder’s Equity)
Return on Equity (ROE) represents the rate of return on the stockholder’s invested capital. This ratio measures a company’s performance in using assets to generate earnings. However, unlike the return on assets ratio, the ROE explicitly considers the financing of those assets. Since the ratio measures the rate of return on the equity capital provided by the owners, the ROE should reflect not only the overall business risk involved, but also the additional financial risk assumed by the common shareholder because of the prior claim of the firm’s debt. Thus this measure of profitability incorporates the results of operating, investing and financing decisions. This common benchmark is used by stockholder’s to determine what to pay for a stock. The higher the ROE, the more the common shareholders will receive in return on their invested capital. A higher return, though, can also involve greater amounts of risk, often due to high leverage.
There are also some limitations to the use of this ratio. ROE is based on earnings, which are influenced by the accounting methods selected by a company. It does not take into account cash flows or the time of cash receipts (present value concepts). Immediate receipts are more valuable than distant ones. In some cases, an average is used for Total Shareholder’s Equity which can also distort the actual return. The ratio tends to penalize companies that invest heavily in research and development, or use little debt. The measure favors companies that pursue high-risk, high-leverage financing strategies or short-term, cost-cutting operating strategies. For this reason, many companies have started to use Economic Valve Added (EVA) and non-financial measures as leading indicators that predict outcomes in financial measures. Despite these drawbacks, ROE is still a standard ratio used by analysts.
Return on Capital:
(Net Income/Total Capital)
The Return on Capital (ROC) indicates the earnings available for all the capital involved in the enterprise (debt, preferred stock, and common stock). This ratio will also be referred to as Return on Investment (ROI) and is a useful means for comparing companies in terms of efficiency of management and the viability of product lines (or management’s deployment of resources). A higher ROC indicates a better utilization of assets and if this ROC is not commensurate with the perceived risk of the company, the question should be raised regarding whether the entity should continue to exist, since capital could be used more productively elsewhere in the economy.
Some problems with ROC are that it does not take into account how the company utilizes the assets on an operating level (see Return on Assets). In addition, the ROC uses earnings and total capital which are both affected by accounting practices.
Return on Assets:
(EBIT/Average Total Assets):
The Return on Assets (ROA) measures a company’s performance in using assets to generate earnings independent of the financing of those assets. The ROA relates the results of operating performance to the investments of a company without regard to how the company financed the acquisition of those assets. The EBIT used in computing ROA is the income before deducting any payments or distributions to the providers of capital (including interest payments).
The ROA has particular relevance to lenders, or creditors since these parties have a senior claim on earnings and assets relative to common shareholders. When extending credit, creditors want to be sure that the ROA generated by the company exceeds the cost of funds to the lender. ROA also provides an indication of the ability of the company to earn a satisfactory return on all assets.
Net Profit Margin:
(Income After Tax, Before Dividends and Extraordinary Items / Nets Sales)
Net Profit Margin focuses on the profitability of each dollar of sales. A simple way to view it is as the proportion of sales that makes its way into profits or as a company’s ability to control the level of expenses relative to revenues generated. If the Net Profit Margin is low compared to other companies within the same industry, then the organization is converting fewer sales dollars into net income that its competitors. This can be an indication of difficulties with the company. A higher Net Profit Margin could indicate greater efficiency in sales and cost containment/reduction.
This ratio is affected by a wide range of variables including Gross Profit Margin, Operating Profit Margin, the effective tax rate, and interest coverage. Changes in Net Profit Margin can be substantial but may be a wrong indication due to the influence of the other variables. For example, the Net Profit Margin may increase but sales might decrease significantly, offsetting the change in margin. Such a situation could even reduce profits.
Gross Profit Margin:
(Net Sales – Cost of Goods / Net Sales):
Gross Profit Margin focuses on the proportion of sales dollars that are available to cover overhead and profits after deducting the cost of goods sold. The higher the Gross Profit Margin, the more funds the organization has to cover expenses after the cost of inventory is considered. This ratio is an indicator of the pricing strength and product cost structure of a company, and it is a useful benchmark of the overall cost of materials, the relative productivity of a company’s production facilities, control over cost of sales, and pricing policies. Changes in Gross Profit Margin, like Net Profit Margin, have to be considered with all other variables to properly assess the affects of chains in the indicator.
The emphasis on facilities and materials limits the measure’s effectiveness in explaining differences across industries, since these measures vary from industry to industry. This is especially true when groupings of similar industries are used for benchmarking comparison.
Operating Profit Margin:
((Net Sales – Cost of Goods Sold – Selling, General, and Administration Expenses) / Net Sales)
The Operating Profit Margin presents the percentage of sales dollars remaining after the cost of operations (Cost of Goods, Selling, General and Administrative Expenses) have been expensed. The ratio indicates effectiveness of a company’s production and sales efforts in generating profits before taxes, finance charges, dividends and provisions for capital needs. The variability of this profit margin over time is a prime indicator of the business risk of a company (the A-Score model uses this type of historical volatility measure in assessing financial distress risk). The higher the Operating Profit Margin, the more effective the company is at generating a profit.
Interpreting trends in the Operating Profit Margin needs to include an analysis of trends in other measures such as sales. For example, a declining trend in the Operating Profit Margin may signal that a company is lowering prices to boost sales in response to its marketplace. In this case, although the margin in decreasing, sales are increasing and profitability might remain roughly the same.
(Net Sales Current Year / Net Sales Prior Year) – 1
This chart shows three years of history for the percentage growth (decline) of revenues for the given company, and for its peer group. A company with strong continued growth in revenues is one that is able to continually sell its service or product in the market place. Erratic growth or decline, on the other hand, may indicate problems in attracting customers for the product or service. A faster or slower change compared to the industry change may indicate gain or loss of market share.
Net Income Trend:
(Pretax Income Current Year / Pretax Income Prior Year) -1
Net Income Trend indicates the growth of the excess of all revenues over all expenses for a company, and its peers, for three years. Decrease in net income would either represent a decrease in revenues or an increase in expenses. Increase in net income would be the reverse. Erratic changes in this percentage could indicate the generation of revenues from one-time, extraordinary items, and thus ought to be investigated.
Operating Income Trend:
(Operating Income Current Year / Operating Income Prior year) – 1
This measure is the same as Net Income Trend above except that Other income and Expense, Taxes, Discontinued Operations, Foreign Currency Translation, and Extraordinary Items have been eliminated from the revenue stream to give an indication of margin directly attributable to the operations of the business. This trend should be examined in concert with Net Income Trend in order to identify any irregularities in reporting income.
(Net Sales / Average of Total Assets)
Asset Turnover looks at how effectively a company is utilizing its capital to generate sales by measuring the company’s ability to generate revenues from a particular level of investment in assets; the greater the Asset Turnover, the greater the company’s performance. A lower asset turnover in comparison to others in the same industry is a signal that a company is carrying a higher and potentially excessive investment relative to its peers. A higher rate, on the other hand, generally reflects a company’s ability to generate sales with fewer assets.
A capital intensive company needs a larger portion of total assets, usually fixed assets, to operate. Capital intensity is also related to the type of industry. For example, utility companies are very capital intensive with high investments in cable, equipment, building, etc. Capital intensity may or may not be a positive or negative aspect. It does depend upon the industry and the environment in which the company must function.
The ratio does have limits. Asset Turnover can drop sharply when capital expansion projects do not immediately yield offsetting sales. In addition, leased assets are not usually recorded on the balance sheet, which means that companies can achieve high asset turnover rates by using leased assets to generate sales. Unless this is known, high turnover rates can be incorrectly interpreted as indicating a stronger position relative to other companies in the industry.
Accounts Receivable Turnover:
(Net Sales / Average Accounts Receivable (Net))
Accounts Receivable (A/R) Turnover indicates how many times the receivables portfolio has been collected during a period which provides an indication of the number of times an organization can convert its receivables into cash in one year’s time. A relatively high A/R turnover may signify that a company has shortened it’s billing period and collects payments on outstanding sales better than other organizations in its industry. A company’s credit policies greatly affect the turnover rate. A high turnover might reflect tighter credit policies and missed sales opportunities. In addition, the A/R Ratio can be misread. As an organization tries to expand its customer base, it might reduce credit restrictions to encourage sales. In doing so, the A/R turnover will be affected, but the overall (long-term) result may be beneficial.
Inventory Turnover: (Cost of Goods Sold / Average Inventory Balance)
Inventory Turnover conveys the number of times the inventory of a company is sold and replaced during a given period (usually one year). This ratio is also referred to as the inventory utilization ratio. It can be considered a measure of efficiency. A high ratio might signal that inventories match market demand while a low ratio could signal a variety of problems such as excessive levels of outdated inventory, incorrect mix, production problems, etc. This measure is important because high inventory turns generally require smooth running operations, correct marketing decisions, and effective organizational interactions between different functional areas such as manufacturing, sales, and product development.
Because sales are recorded at market value and inventories are normally carried at cost, it is more realistic to obtain the turnover ratio by dividing inventory into cost of goods sold rather than sales. However, it is conventional to use sales as the numerator because that is the practice of compilers of published financial data. So in order to provide comparability, the sales figure is the numerator.
The inventory turnover ratio combined with the A/R ratio are the building blocks for determining the length of the operating cycle. An organization with a shorter operating cycle, high Inventory Turnover and high A/R Turnover, has a greater potential to be profitable. It signifies that the company can sell its products efficiently and receive payment quickly.
2. Financial Status Ratios
(Current Asset / Current Liabilities)
The current ratio indicates a company’s ability to pay off short term obligations with current assets. At a glance, it gives an investor an idea of how many dollars included in current assets can cover $1 of current liabilities. The greater the ratio the more dollars in current assets to pay current liabilities. The measure is frequently used to assess investment risk: How liquid is the company? How easily it can respond to changes in its environment that might demand near-term cash outlays? In general, a company that has a small inventory and readily collectible accounts receivable can operate safely with a lower current ratio than a company whose cash flow is less liquid and less dependable.
The ratio’s primary limitation is that it includes inventory which might not be readily convertible to cash. The Quick Ratio attempts to remove this limitation, examining how well a company can respond in a near-crisis situation without selling inventory.
(Current Assets – Inventory / Current Liabilities)
The Quick Ratio or Acid Test Ratio is a measure of a company’s ability to pay off short term obligations without relying on the sale of inventories, which may not be as liquid as certain other current assets. Unlike the Current Ratio, it includes only a company’s most liquid assets. Like the Current Ratio, it is used as a way to assess investment risk which gives an idea of how many dollars of current assets cover $1 of current liabilities. The greater the ratio is, the more liquid assets a company has available to handle current obligations. Assuming there is nothing happening to slow or prevent collections, a quick ration of 1 to 1 or better is usually satisfactory.
Long Term Debt to Capital:
(Long Term Debt / (Long Term Debt + Total Common Shareholders’ Equity, Preferred Stock, and Minority Interest)).
Financial leverage occurs when a company finances its assets through debt instruments rather than equity. Long Term Debt to Capital measures the extent of this leverage. The larger the ratio, the more leveraged the company. A company with a higher leverage has a smaller percentage of owner’s equity relative to debt in the capital structure. If the company earns more on its investments financed with borrowed funds than it pays in interest costs, then the return on the owners’ capital is magnified or “leveraged.” Since owner’s equity is the denominator in ROE, a highly leverage company has the potential to achieve a greater ROE. However, this potential for greater returns may be matched by higher risk. Creditors, in general, prefer low debt to capital ratios, since the lower the ratio, the greater the cushion against creditors’ losses in the event of liquidation. While owners might patiently wait for returns, creditors demand repayments in good times and bad. However, comparison of this ratio can be misleading. The most significant reason for difficulties is that the market value and interest costs of the debt, which can be more important factors, are not reflected in the Long Term Debt to Capital Ratio.
In assessing the Long Term debt to Capital ratio, analysts customarily vary the standard in relation to the stability of the company’s earnings and cash flows from operations. The more stable the earnings and cash flows, the higher the debt ratio considered acceptable or safe. In addition, with the consideration of long term debt, it is also good to review other long term obligations. Certain long term obligations, not included on the balance sheet, require the company to make a series of fixed payments. For example, if an organization uses long term operating leases to function, these amounts should be included in the ratio to get a better sense of the company’s actual leverage.
Interest Coverage Ratio:
(EBITDA/ Interest Expense)
Interest Coverage indicates how many times interest charges have been earned by the company on a pre-tax basis. From the risk perspective of a credit analyst, a failure to meet interest payments would qualify as a default under terms of indentured agreements. The interest coverage ratio measures a margin of safety and assesses the probability of a company’s failing to meet required interest payments. The amount of safety desirable depends on the stability of a company’s earnings.
One drawback is that the ratio uses earnings rather than cash flows in the numerator. Companies pay interest and other fixed payment obligations with cash, not with earnings. As a result, many analysts will calculate an interest coverage ratio with operating cash flow as opposed to earnings. When the value of the ratio is relatively low (for example one to two times), some measure of cash flow, such as EBITDA minus capital expenditures, should be used in order to determine if a cash flow problem exists.
It is interesting to note that 1 minus the reciprocal of the coverage ratio indicates how much earnings could decline before it would be impossible to pay the fixed interest charges; for example, a coverage ratio of 5 means earnings could decline by 80% (1-(1/5)), and the company could still pay the fixed financial charges.
Long Term Debt to Cash Flow:
(Total long term debt / (Income before extraordinary items + deferred tax provision + depreciation and amortization expense + equity losses (earnings).
Companies operate on actual cash flow generated and this ratio shows the relationship between the cash generating capability of the company’s operations and the eventual cash outflows required to pay outside creditors. It ignores other typical cash requirements such as capital expenditures since these are often delayable at the company’s discretion while debt payments are not. It also does not consider maturity schedules which obviously are a key determinant of when the cash is needed. Despite these drawbacks, its simplicity makes it a useful initial indicator of potential problems. This ratio measures the number of years it would take the company to pay off its long-term debt based on current cash flow.
3. Market Value Ratios
(Market Price Per Common Share / Book Value Per Common Share)
The ratio indicates the amount shareholders are willing to pay for the net asset value underlying a share of stock. A ratio greater than 1 suggests that investors consider the net assets to be more valuable than book value. Usually companies with relatively high rates of return on equity sell at higher multiples of book value than those with low returns. Thus, the more valuable the stock to investors, the higher the Price/Book Ratio will be.
This ratio also indicates the value that the market attaches to the management and the organization of the company as a going-concern. Since book value represents historical cost, a well-run company with strong management and an organization that functions efficiently should have a market value greater than, or at least equal to, book value. A market to book value ratio of less than one, indicates that the market values the company at less than the book value of its net assets. Such result should be viewed as an indicator of risk.
The comparability of the ratio is limited by differences between the book value of large intangible and undervalued assets and their true worth and differences in the age and depreciation of property, plant, and equipment.
(Market Price Per Common Share / Earnings Per Share)
The Price/Earnings Ratio shows how much investors are willing to pay per dollar of reported or projected profits. The P/E ratio which is also commonly referred to as the multiple, gives an investor an idea of how much they are paying for a company’s earning power. The higher the P/E, the more the investors are paying, and therefore the more earnings growth they are expecting. In general, high P/E stocks – those with multiples of 20 – are typically young, fast-growing companies and companies in high growth industries. They are far riskier to trade than low P/E stocks, since it is easier to miss high-growth expectations than low-growth predictions. Low P/E stocks tend to be a low-growth or mature industries, in industries that have fallen out of favor, or in old, established, blue-chip companies with long records of earnings stability and regular dividends. In general, low P/E stocks have higher yields than high P/E stocks, which often pay no dividends at all.
The P/E ratio may either use the reported earnings from the latest year (called a trailing or LTM (Last Twelve Months) P/E) or employ analyst’s forecast of next years earnings (called a forward P/E). The trailing P/E is listed along with a stock’s price and trading activity in the daily newspapers. For example, a stock selling for $20 per share that earned $1 last year has a trailing P/E of 20. If the same stock has projected earnings of $2 next year, it will have a forward P/E of 10.
There are several limitations of using P/E Ratio to assess a company’s position. When using a trailing P/E, the market price (numerator) is focused on future returns while earnings (denominator) are historical in nature. Significant fluctuations in the P/E ratio can occur over time caused by erratic earning patterns. Also, cross-company comparison is difficult due to different accounting and financing techniques. These considerations should be taken into account when using the ratio to determine a company’s relative position.
(Market Price Per Common Share / (Net Income Before Interest, Taxes, and Extraordinary Items))
Similar to the P/E ratio, Price/EBIT reflects how much investors are willing to pay per dollar of reported or projected operating profits. As discussed above, one of the limitations of the P/E ratio is that certain accounting and financing decisions (e.g. one-time charges and debt-equity mix) of a company can impact net earnings. The Price/EBIT ratio adjusts the earnings component to reflect operating results in an attempt to calculate a relative multiple that is not affected by certain accounting and financing decisions. Price to EBIT reflects the investors’ attitudes on operating earnings, both trailing and future. A relative comparison such as Price/EBIT between similar companies will provide a better understanding of how the market values the operations of a business than the P/E in some cases. The higher the ratio, the higher the expected EBIT in the future.
The limitations of the Price/EBIT ratio are similar to those encountered when using the P/E Ratio. Again, the comparison of future returns based on historic earnings is used. Fluctuations can occur due to erratic revenues or expenses. Although the Price to EBIT ratio removes some accounting affects, comparing companies in the same industry can still be difficult because of such issues as inventory methods.